Is a type of unsecured promissory note issued by large financially strong firms?

22.1 Commercial Paper programmes

The issuers of CP are often divided into two categories of company, banking and financial institutions and non-financial companies. The majority of CP issues are by financial companies, as noted in Table 22.1. Financial companies include not only banks but the financing arms of corporates such as General Motors, Ford Motor Credit and Chrysler Financial. Most of the issuers have strong credit ratings, but lower-rated borrowers have tapped the market, often after arranging credit support from a higher-rated company, such as a letter of credit from a bank, or by arranging collateral for the issue in the form of high-quality assets such as Treasury bonds. CP issued with credit support is known as credit-supported commercial paper, while paper backed with assets is known naturally enough, as asset-backed commercial paper. Paper that is backed by a bank letter of credit is termed LOC paper. Although banks charge a fee for issuing letters of credit, borrowers are often happy to arrange for this, since by so doing they are able to tap the CP market. The yield paid on an issue of CP will be lower than a commercial bank loan.

Although CP is a short-dated security, typically of three- to six-month maturity, it is issued within a longer term programme, usually for three to five years for euro paper; US CP programmes are often open-ended. For example a company might arrange a five-year CP programme with a limit of $100 million. Once the programme is established the company can issue CP up to this amount, say for maturities of 30 or 60 days. The programme is continuous and new CP can be issue at any time, daily if required. The total amount in issue cannot exceed the limit set for the programme. A CP programme can be used by a company to manage its short-term liquidity, that is its working capital requirements. New paper can be issued whenever a need for cash arises, and for an appropriate maturity.

Issuers often roll over their funding and use funds from a new issue of CP to redeem a maturing issue. There is a risk that an issuer might be unable to roll over the paper where there is a lack of investor interest in the new issue. To provide protection against this risk issuers often arrange a stand-by line of credit from a bank, normally for all of the CP programme, to draw against in the event that it cannot place a new issue.

There are two methods by which CP is issued, known as direct-issued or direct paper and dealer-issued or dealer paper. Direct paper is sold by the issuing firm directly to investors, and no agent bank or securities house is involved. It is common for financial companies to issue CP directly to their customers, often because they have continuous programmes and constantly roll-over their paper. It is therefore cost-effective for them to have their own sales arm and sell their CP direct. The treasury arms of certain non-financial companies also issue direct paper; this includes for example British Airways plc corporate treasury, which runs a continuous direct CP programme, used to provide short-term working capital for the company. Dealer paper is paper that is sold using a banking or securities house intermediary. In the US, dealer CP is effectively dominated by investment banks, as retail (commercial) banks were until recently forbidden from underwriting commercial paper. This restriction has since been removed and now both investment banks and commercial paper underwrite dealer paper.

Although CP is issued within a programme, like MTNs, there are of course key differences between the two types of paper, reflecting CP’s status as a money market instrument. The CP market is issuer-driven, with daily offerings to the market. MTNs in contrast are more investor-driven; issuers will offer them when demand appears. In this respect MTNs issues are often “opportunistic”, taking advantage of favourable conditions in the market.

4.2.1.1.6 Commercial papers

Commercial papers are unsecured short-term promissory notes with maturity mostly not exceeding 270 days. They are issued by large corporations to meet short-term obligations. In terms of dollar volume, commercial paper occupies the second position in the money market after Treasury bills. Commercial papers are used typically by large creditworthy corporations with unused lines of bank credit and have a low default risk. Credit rating agencies provide ratings for these commercial papers. The role of banks is to act as agents for the issuing corporations, but they are not obligated for the repayment of commercial paper.

Commercial paper is usually sold at a discount from face value and carries higher interest repayment rates than bonds. Commercial papers can be issued in two ways. Corporations can market the securities directly to buy and hold investors like money market funds. Or the commercial paper is sold to a dealer who sells the paper in the market. Dealers include large securities firms and subsidiaries of bank-holding companies. The yield for commercial paper holders is the annualized percentage difference between the price paid for the paper and the par value using a 360-day year.

US commercial paper markets are credit rated into the categories of AA nonfinancial, A2/P2 nonfinancial, AA financial, and AA asset backed. Table 4.1 highlights US Commercial paper market statistics with respect to number of issues and average amount during the period 2010-2012. Table 4.2 provides the value of commercial paper issued in the major currencies US dollar, euro, and pound sterling during 2011-2012.

Table 4.1. US Commercial Paper Market Statistics

Source: http://www.federalreserve.gov/releases/cp/volumestats.htm#total_mkt

Table 4.2. Commercial Papers: Currency Segregation (in Billions of US Dollars)

Source: BIS.org

Asset-Backed Commercial Paper (ABCP)

ABCP is commercial paper secured by designated corporate assets, typically receivables. The term ABCP is almost oxymoronic since commercial paper is understood to be the traded, short-term unsecured debt of corporations. The maturity is typically 90–180 days. Figure 11.6 illustrates how an ABCP program works.12

A bank establishes a “special purpose corporation” (SPC). The SPC purchases credit card receivables or other assets from a corporation (the seller) in need of funding. To finance this purchase, the SPC issues commercial paper that is secured by the assets purchased by the SPC. The bank provides credit enhancement enabling the SPC to obtain a high credit rating for the commercial paper, typically through overcollateralization and/or a standby letter of credit. This credit enhancement enables the SPC to obtain a high credit rating for the commercial paper.

The ABCP market, which came into existence in 1983, has expanded rapidly, growing to a multibillion-dollar market within a decade. Fitch Investors Service reports that, in mid-1993, 175 ABCP programs were in operation, representing $75 billion in outstanding commercial paper and $150 billion in commitments. By the end of 2006, ABCP outstanding in the United States had grown to $1.1 trillion, larger than the amount of unsecured (non-asset-backed) commercial paper outstanding and a significant portion of the “shadow banking system” in the United States.13 Global banks like Societe Generale (France), Deutsche Bank (Germany), Barclays Bank (United Kingdom), UBS (Switzerland), Sumitomo Mitsui Banking Corporation (Japan), and Canadian Imperial Bank of Commerce (Canada) were big players in this market. Following the financial crisis during which the ABCP market was under enormous stress and fell out of favor with many, outstanding volume dropped below $400 billion by 2010, and by the end of 2014 to slightly over $200 billion.14 The boom in the ABCP market is seen as one of the contributors to the 2007–2009 financial crisis. ABCP was used to fund off balance sheet special purpose vehicles (and conduits), and considered fragile as it supported long-term (and often opaque) assets that were typically financed with very short-maturity liabilities.15 We will discuss this more in Chapter 14.

For now, it is still interesting to ask why had ABCP grown so much in popularity in the precrisis years? We will examine both the demand and supply sides. On the demand side, ABCP offers some firms lower cost funding than either “regular” (unsecured) commercial paper or a bank loan. Regular commercial paper may either be unavailable or too costly because of the high cost of moral hazard owing to the unsecured nature of the paper (recall Chapters 7 and 878). A bank loan may be too costly because of capital and reserve requirements. One reason why ABCP lowers the firm’s funding cost is the credit enhancement provided by the bank. Not only does this directly lower the investor’s risk in holding the paper, but it also signals the bank’s involvement in monitoring the borrower16 and is certification that the borrower is creditworthy. Thus, the basic screening and monitoring services provided by the bank play a key role in the ABCP market.

On the supply side, the risk-based Basel II (see Chapter 15) capital rules increased the benefits of ABCP to banks. If the bank were to extend a loan to the borrower, it would not only need to keep reserves against the deposit used to fund the loan, it would also need to set aside substantial capital (under Basel I, this was 8%). With an ABCP, the bank would need to keep capital equal to say 8% of only the credit enhancement (typically a fraction of the total borrowing). For example, a $1 billion bank loan would need $80 million in bank capital, but with an ABCP program, a bank might issue a letter of credit equal to only 10% of the total amount, so that only $8 million in capital would have to be set aside.17 Thus, as with other off-balance sheet products, banks are able to earn fee income without posting as much capital as with conventional funding.

As already noted, the financial crisis of 2007–2009 took its toll on the ABCP market. While ABCP had become popular for regulatory arbitrage, the off balance sheet structures often did not reduce the risk for the issuing bank. Via liquidity guarantees much of the risk would come back to haunt the banks. In the summer of 2007, ABCP outstanding began a precipitous decline. The trigger had to do with growing concerns about the default risks of subprime and other mortgages.18

The collapse of the ABCP market also created problems for money market mutual funds (MMFs) that invest trillions of dollars on behalf of individuals, pension funds, municipalities, businesses, and others. These investments are close substitutes for bank deposits from the standpoint of investors. Many MMFs invested in ABCP, and met the withdrawal demands of their investors by selling ABCP in a liquid market, prior to 2007. Because liquidity was drained out of this market during the financial crisis, it was difficult for MMFs to meet the withdrawal demands of their investors. To help MMFs cope with this problem and to preclude further downward pressure on ABCP prices due to fire sales of these securities by MMFs, the Federal Reserve established the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF).19

The AMLF was created by the Federal Reserve under the authority of Section 13(3) of the Federal Reserve Act, which permitted the Board, in unusual circumstances to authorize Federal Reserve Banks to extend credit to individuals, partnerships and corporations. Under the AMLF program, the Federal Reserve provided nonrecourse loans to U.S. depository institutions, U.S. bank holding companies, and the U.S. branches and agencies of foreign banks. These loans were fully collateralized by the ABCP purchased by the AMLF borrower. These institutions that received the loans used them to purchase eligible ABCP from MMFs, so the MMFs were the institutions that were the primary intended beneficiaries of the AMLF.

The AMLF facility was administered by the Federal Reserve Bank of Boston, which was allowed to make AMLF loans to eligible borrowers in all 12 Federal Reserve districts. The facility was announced on September 19, 2008, and closed on February 1, 2010.

The AMLF program is a good example of how government liquidity-provision intervention can help in markets that are experiencing serious liquidity shortages or breakdown either due to temporarily distorted beliefs that cause overreactions to adverse events or due to informational asymmetries.20 Whether a liquidity crunch was the main problem during the subprime crisis is another issue altogether, and one that we will visit in a later chapter on the financial crisis of 2007–2009.

4.4 Commercial Paper Yields

Commercial paper is a discount instrument. There have been issues of coupon CP, but this is very unusual. Thus CP is sold at a discount to its maturity value, and the difference between this maturity value and the purchase price is the interest earned by the investor. The CP day-count base is 360 days in the US and euro markets, and 365 days in the UK. The paper is quoted on a discount yield basis, in the same manner as Treasury bills. The yield on CP follows that of other money market instruments and is a function of the short-dated yield curve. The yield on CP is higher than the T-bill rate; this is due to the credit risk that the investor is exposed to when holding CP; for tax reasons (in certain jurisdictions interest earned on T-bills is exempt from income tax) and because of the lower level of liquidity available in the CP market. CP also pays a higher yield than Certificates of Deposit (CD), due to the lower liquidity of the CP market.

Although CP is a discount instrument and trades as such in the US and UK, euro currency Eurocommercial paper trades on a yield basis, similar to a CD. The discount rate for an instrument was discussed in Chapter 2. The expressions below are a reminder of the relationship between true yield and discount rate.

(4.13)P=M1+r×(days/year)

(4.14)rd=r1+r×(days/year )

(4.15)r=rd1-rd×(days/year)

where M is the face value of the instrument, rd is the discount rate and r is the true yield.

Example 4.3

CP Calculations

Provision of Liquidity Directly to Borrowers and Investors in Key Credit Markets

These interventions included the Commercial Paper Funding Facility (CPFF), ABCP MMF Liquidity Facility (AMLF), Money Market Investors Funding Facility (MMIFF), and the Term Asset-Backed Securities Loan Facility (TALF). Of these, we earlier discussed the AMLF in the chapter on securitization (see Chapter 11).

The CPFF was established in October 2008 to provide liquidity to U.S. issuers of commercial paper. Under the program, the Federal Reserve Bank of New York provided 3-month loans to a specially created limited liability company that then used the money to purchase commercial paper directly from issuers. The CPFF was dissolved on August 30, 2010.

The MMIFF was designed to provide liquidity to U.S. money market investors. Under this facility, the Federal Reserve Bank of New York could provide senior secured loans to a series of special purpose vehicles to finance the purchase of eligible assets from eligible investors. The MMIFF was announced on October 21, 2008 and dissolved on October 30, 2009.

TALF was created to help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities collateralized by consumer and small-business loans: auto loans, student loans, credit card loans, equipment loans, floor plan loans, etc. The goal was to revive the consumer-credit securitization market. The facility was launched in March 2009 and dissolved by June 2010.

Commercial Papers

The players in money market recognize CP as a risky debt instrument. I should explain the factors underlying the risk in some detail. I do so for one reason. There is a tendency to think that a CP strictly is a risk asset that has nothing to do with the liabilities concerns of the treasury function. Such thinking is erroneous. Let me discuss the insights that shed light on the distinctive features of CPs as money market instrument.

A bank may want to arrange for credit facilities which third parties provide for customers of the bank. This financing arrangement works under particular conditions. There must be a customer—usually a corporate borrower—that is in need of a credit facility which the bank is unable to grant due, perhaps, to portfolio constraint. The customer requests the bank to raise the funds it needs at market rate of interest from third party investors who may be individuals, companies, or organizations. Based on prevailing money market conditions, the bank negotiates the terms of the borrowing with the borrower. Thereafter, and on behalf of the borrower, the bank tries to attract prospective investors that might be interested in providing the money to its customer. The bank fulfills this role with the facility of CP offer.

Strictly speaking, and as is commonly understood among bankers, the bank in foregoing illustration is simply sourcing, not lending, funds to its customer. The bank does not assume any credit risk in this process and financial intermediation service. The actual lenders are the third party investors from whom the bank raises the required funds through sale of CP. Doing so, and in marketing the CP, the bank will be emphasizing the borrower’s integrity, cash flow strength, reputation, and creditworthiness, among other risk mitigating factors. Once it has done this, prospective investors make the ultimate decision of whether or not to purchase (i.e., invest in) the CP. The prospective investors solely assume the risk of their investment in the CP—relying, in doing so, on any established goodwill of the borrower. It is expected that as rational human beings and economic units, the prospective investors should make good lending decision. Their purchase of the CP should base on their independent appraisal of the financial strength (especially, the short and long-term liquidity and stability) of the borrower.

Other features and risks of commercial paper

In order to have a standardized use and reporting of commercial papers, the CBN prescribes the following essential features of this financial instrument:

As with bankers' acceptances, funds collected from customers for investment in commercial papers should be treated as deposits until such funds are invested in the instruments. Investors in commercial papers should also be made aware of the identity of the issuers of the instruments.

Commercial papers should only be guaranteed and not accepted since the intermediating bank is only a secondary obligor.

When a bank invests in a commercial paper, by disbursing its own funds, the transaction should be reported on-balance sheet and treated as a loan. However, if the bank merely guarantees the instrument, it should be shown off-balance sheet as a contingent liability.

Where a commercial paper, which had been guaranteed by a bank crystallizes by virtue of the inability of the issuer to pay on maturity, the bank as the secondary obligor is bound to redeem its guarantee by disbursing funds to the beneficiary. The transaction should then be reported on-balance sheet as a loan.

The bank may charge an appropriate commission in line with the bankers' tariff for providing the guarantee.

From the foregoing, it is apparent that a commercial paper could actually become a normal credit facility. But this depends on its treatment by the bank. Does the bank want to directly invest in the commercial paper by disbursing the required funds to the borrower? Should it wait to see if the commercial paper, as offered by the borrower, would succeed or fail and invest when the latter happens? What will happen if a guaranteed commercial paper fails in the market and, as the secondary obligor, the bank redeems it? In the first two cases, the act of direct investment in a commercial paper exposes a bank to on-balance sheet credit risk. In the third instance, the nature of the bank's liability will change from contingent to direct exposure. In all cases, whether a bank takes credit risk or not underlies the caution it should exercise in marketing a CP on behalf of its customer.

10.2.2 Commercial Papers

Commercial papers are securities issued by companies—in particular, large enterprises—to raise resources for their financial needs. They are tradable on the money market, and their maturity is generally between 1 and 9 months.

When issuing commercial papers, banks, finance companies, and corporations are promising to pay the face value on the note maturity date. In fact, this is an unsecured form of credit, as no collateral is required. For this reason, only firms with a great credit rating are able to sell their commercial papers at a reasonable price.

Commercial papers have low marketability, as there is not a secondary market, even though the issuer could repurchase the note prior to maturity. Generally, being issued commercial papers is cheaper than getting a loan from a bank.

The U.S. Federal Reserve System (FED) publishes data on the commercial paper rates supplied by the Depository Trust & Clearing Corporation. Table 10.2 lists the commercial papers’ annual average rates. They include calculation programs with at least one “1” or “1+” rating in the AA2 financial and AA nonfinancial commercial paper interest rate, but no ratings other than “1” for the short-term credit rating and programs with at least one “AA” rating, including split-rated issuers for the long-term credit rating. The A2/P2 nonfinancial category includes programs with at least one “2” rating, but no ratings other than “2” in relation to the short-term credit rating and programs with at least one “A” or “BBB”/“BAA” rating, including split-rated issuers, but none with any ratings outside the “A”–“BBB”/“BAA” range for the long-term credit rating.

Table 10.2. Commercial Paper Rates for Different Categories as of March 31, 2014

Source: www.federalreserve.gov.

7.3 Replacing the Liquidity Line: The Committed Repo Facility

In Chapter 1 we noted that the principal credit backing got both conventional and asset-backed CP programmes was the liquidity facility. This is a stand-by line of credit that the CP conduit is able to draw on if, for any reason, it is unable to issue CP or repay maturing CP. The facility is provided by a bank and carries two charges:

the standing charge, usually calculated as either a fixed fee or a basis point multiple of outstanding CP at each charging date, and payable either monthly or quarterly in advance;

the actual borrowing cost, an interest rate charge, if the line os drawn upon.

The standing fee is a function of the credit quality of the originator or programme sponsor. It is a significant cost of any programme. A recent development for asset-backed CP vehicles has been the replacement of part or all of the liquidity line with a “committed repo” facility, (or committed total-return swap facility), which carries with it a lower fee and thus saves on costs.

Under the committed repo a bank will undertake to provide a repo funding facility using the vehicles assets as collateral. Thus, in the event that CP cannot be repaid, the vehicle will repo out its assets to the repo provider, enabling it to meet maturing CP obligations. Assets will be repoed at a margin or haircut; this margin would need to be financed from a conventional liquidity or other credit enhancement reserve. Hence unless some other sources of funding other than a liquidity line is available, it is not possible to replace the entire line with the committed line. The credit quality of the underlying assets will determine the size of the intended margin, as well as the fee for the facility itself.

We provide at Figure 7.15 a suggested Term Sheet for a committed repo facility for a ABCP vehicle. Note that this can be set up also as a committed Total Return Swap for the conduit. The repo line charges a standing charge fee of 7 basis points, payable on the outstanding amount of CP at each charging date. It is available up to a 80% of this amount, which means that the vehicle will need to retain at least a 20% backing from a conventional Liquidity line, or provide some other backing such as a reserve fund of this minimum value.

24.7 Municipal money market instruments

Short-dated instruments in the municipal market are known as notes. There are also tax-exempt commercial paper, and variable-rate obligations which are similar to floating-rate notes. Notes in the municipal market are given special names, for example there are revenue anticipation notes (RANs), tax anticipation notes (TANs), grant anticipation notes (GANs) and bond anticipation notes (BANs). They are similar to discount instruments in the money markets, and are often issued as short-term borrowings to be redeemed after receipt of tax or other proceeds. Essentially the notes are issued to provide working capital, because the receipt of cash flows from taxation and other local government sources is irregular. The typical maturity of a note is three months, while the longest maturity is 12 months. In most cases tax-exempt notes are issued with credit backing in the form of a bank letter of credit, a bond insurance policy or a lending line at a bank.

Municipal borrowers issue commercial paper, which is similar to corporate CP and may have a maturity ranging from 1 to 270 days. It is known as tax-exempt commercial paper.

Another money market instrument is the variable-rate demand obligation (VRDO). This is a floating-rate security that has a long-dated maturity but has a coupon that is re-set at the very short-dated interest rate, either the overnight rate or the seven-day rate. The securities are issued with a put feature that entitles the bondholder to put the issue back to the borrower at any time, upon giving seven days’ notice. The bonds may be out to the issuer at par.